Strong Results Show Rite Aid’s Remodeling Initiative Is Paying Off

Rite Aid (NYSE: RAD), one of the leading drugstore chain in the U.S., reported its Q2 2014 earnings on September 19. Fiscal 2013 marked the company’s first profitable year in five years and the positive trend has continued so far this year. Backed by its store re-modeling initiative, efficient cost management and customer loyalty programs, Rite Aid claims that it has seen a better-than-expected performance in the first two quarters of fiscal 2014.

At $6.3 billion, Rite Aid reported a marginal rise (0.76% y-o-y) in its revenue base mainly driven by higher pharmacy sales. Though its front-end same-store sales declined by 0.3%, its pharmacy same-store sales climbed by 1.7%, which led to a 1% increase in Rite Aid’s overall same-store sales, compared to Q2 2013. Earning $33 million as net income, compared to a net loss of $39 million a year ago, Rite Aid continued to remain profitable for the third consecutive quarter. Its stock price increased by approximately 15% after the company reported its Q2 2014 earnings.

While Rite Aid believes that its growth in the second half will slow down, it remains confident about its long-term prospects as its turnaround strategy continues to reap benefits for the company. Despite the negative impact of the dispute settlement between Walgreen and Express Scripts, Rite Aid is confident of retaining 75% of scripts gained from Walgreen customers.

The improvement in net income in Q2 2014 was primarily driven by Rite Aid’s low expense base and growth in its adjusted operating margin which was partially offset by a $62.2 million loss on debt retirement related to the company’s refinancing initiative announced in June this year.

Rite Aid recorded its 11th consecutive quarter of y-o-y growth in adjusted EBITDA which was 56% higher compared to Q2 2013. Increasing proportion of generic drugs, strong pharmacy margins, improving front-end margins, strong expense control and the recovery of $23.5 million from the settlement of a prescription drug antitrust case are the key factors driving improvement in margins. Additionally, Rite Aid’s debt refinancing initiative in July 2013, to take advantage of the low interest rate scenario and to extend the maturity of its existing debt, lowered its interest expense.

Lower Generic Penetration Rate May Impact Gross Margins In The Second Half of 2014

The rise in generic penetration has enabled Rite Aid to become more profitable in spite of lower sales, as generic drugs offer over 50% higher margins compared to branded drugs. The total generic dispensing rate, which implies the percentage of generic drugs in a consumer’s prescription, grew to 78.5% in 2012 (calendar year), from 74.1% and 71.5% in 2011 and 2010, respectively.

However, in its earnings call Rite Aid mentioned that the pace of generic drugs substitution has slowed down recently which can limit the future growth in pharmacy gross margins. The introduction of new generic drugs had a 2.49% negative impact on Rite Aid’s top line growth in Q2 2014 as compared to a 7.5% negative impact in Q2 2013. Lower generic substitution combined with the expected flat front-end gross margins this year will have a negative impact on Rite Aid’s bottom line in the second half of fiscal 2014.

Nevertheless, an estimated $15 billion worth of branded product will come off patent in the next three years, opening them to competition from generic drugs. [1] Thus, we believe that Rite Aid will manage to retain margins at the current level.

Strengthening Rite Aid’s Image As A Health & Wellness Store

Rite Aid aims to transform majority of its stores into neighborhood destinations for health and wellness. At the end of Q2 2014 the company had remodeled a total of 1,019 stores and remains on track to complete 1,200 by the end of this year. Rite Aid claims that its Wellness stores outperformed all its other stores in Q2 2012. Front-end same-store sales in the Wellness Stores exceeded the non-Wellness Stores by 3.4% and script growth in the Wellness Stores exceeded the non-Wellness Stores by 0.9%.

Loyalty programs such as the Wellness+ program has helped improve its front-end as well as pharmacy sales in the last few quarters, and remain a key component of Rite Aid’s health and wellness offering. The Welness+ program helps strengthen the relationship with customers in turn increasing the number of loyalty shoppers at Rite Aid. At present the company has more than 25 million active Wellness+ members.

Rite Aid recently launched its Wellness65+ program aimed at senior patients who are known to be higher spenders in the pharmacy category. By the end of Q2 2014, more than 930,000 senior citizens had enrolled in the program.

According to a 2012 RAND Health study, wellness programs are the rage in corporate America, with half of surveyed companies offering wellness promotion programs. [2] Such loyalty programs and similar initiatives can enable Rite Aid to broaden its customer base.

Fiscal 2014 Outlook

Rite Aid updated its estimate for fiscal year 2014 based on the stronger than expected performance in the first half of the year. Nevertheless, it expects a lower second half performance as compared to fiscal 2013.

– Total sales between $25.1 billion and $25.3 billion.

– Adjusted EBITDA in the range of $1.240 billion – $1.3 billion.

– Same-store sales to increase/decrease by 0.5% (includes the anticipated negative pharmacy sales impact of 2.4% from new generic introductions and continued reimbursement rate pressure).

– Net income in the range of $182 – $268 million or diluted EPS of $0.18 – $0.27.

– Capex of $400 million with $175 million allocated to remodels and $65 million for file buys.

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